Should severance pay be consistent for all workers?

Main features of dual labor markets

Spain provides one illustration of the effects that temporary contracts might have in the long term. For decades, more than 30% of Spanish employees have worked under temporary contracts—although the rate is currently around 25% as a result of massive layoffs made during the great recession, which primarily affected temporary workers (Figure 1). Poland, Portugal, the Netherlands, Sweden, and France are also well above the EU average of 12.8% (2013). It would be fair to assume that without substantial changes, temporary contracts will continue to be the predominant entry route into employment in Spain and, when the economy recovers, that temporary employment will rise once again. This indeed appears to be the case, as almost 92% of all new hires in Spain during 2014 were based on temporary contracts. The same is also true for Italy, where the corresponding figure was 83.4% in 2013.

As shown in the Illustration, Spain and Italy are typical examples of dual labor markets, in which temporary and permanent contracts substantially differ. One of the most notable differences between the two types of contract is the level of employment protection each one entails. Indeed, during the first two years “on the job” in Spain, and the first three years in Italy, severance payments are based on eight days per year of service. The 2012 reform in Spain and the 2015 Job Act in Italy amended this to 12 days. Once the duration of the job goes beyond the maximum allowed by the law (which is two years in Spain and three years in Italy), severance payments in both countries jump to more than 30 days per year of service. One study shows that this large gap in severance costs between these two types of workers makes employers reluctant to transform temporary contracts into permanent ones—and it is this which effectively forms the basis of the “dual” character of these two labor markets [1].

The study also shows that the large discontinuity created by conventional Employment Protection Legislation (EPL) schemes in dual labor markets has negative consequences for unemployment, human capital, and innovation, as the discontinuity leads to excessive turnover in the labor market. Empirical evidence of the impact of temporary work on labor market outcomes shows that, in general, temporary contracts do not improve access to permanent contracts and, furthermore, that such contracts create excessive wage pressure, low training investments by firms, and the adoption of mature rather than innovative technologies [2], [3], [4], [5].

Thus it is quite well established that dualism in the labor market—i.e. the coexistence of workers with quite different seniority rights—has significant negative consequences on wages, human capital accumulation, and even for the political economy of labor market reforms. There is also evidence to show that permanent workers are more productive than temporary workers.

A recent paper that analyzes Spanish social security data finds that groups of native male high-school dropouts, who entered the labor market just after the total liberalization of temporary contracts in Spain that took place in 1984, experienced worse labor market outcomes than similar groups who just preceded them [6]. Specifically, they experienced almost 200 days less in duration of employment (a 7% drop) and their wages were reduced by approximately 22% in the long term. It is for this reason that there are increasing concerns about the role that temporary contracts are playing in this and other European countries. For example, Germany, the Netherlands, and Poland are using these contracts intensively as a way of both reacting to changes in demand and introducing more flexibility into labor relations.

In contrast to this, some other European countries have developed an alternative institutional system that is usually referred to as the “flexicurity model.” The essential feature of this model is a combination of two “pillars”: first, less rigid EPL affecting all workers equally; and, second, more generous unemployment benefits coupled with well-developed, active labor market policies.

The negative side of temporary contracts is especially evident once an economy enters a recessionary period. Spain lost approximately 18% of its total employment between 2007 and 2013. Although the strong negative shocks experienced around the world as a result of the economic crisis were a very significant factor, it is also the case that poor sectoral specialization played an important part in Spain’s employment crash. In addition, it is now quite accepted that the inadequate design of Spanish labor market institutions was one of the main factors behind the extremely volatile employment outcome [7].

In summary, taken together with a rigid collective bargaining system, which sets wages at the sector and regional levels rather than aligning wages with the specific conditions within individual firms, the badly designed contract provision in Spain resulted in its economy being heavily reliant on quantity adjustment rather than price or wage adjustment during the crisis. There is also widespread agreement that the slow response of negotiated wages to the worsening economic climate contributed to the severity of the crisis in Spain.

A similar situation to that which occurred in Spain also took place in Portugal and in Greece. In contrast, however, countries such as Germany and France, which also faced similar or even greater declines in economic activity, experienced considerably smaller reductions in employment than the peripheral countries. The essential difference between the two sets of countries was the prevailing institutional policy for the hiring and laying off of temporary and permanent workers. Indeed, prior to 2010, the difference in Spain derived from the huge gap between the severance pay for workers with permanent contracts versus temporary contracts. For permanent contracts, the number of days of wages per year of service (days “pyos”) paid in cases of unfair dismissal was 45; in the case of fair dismissal it was 20 days. In contrast, the equivalent number of days “pyos” for temporary contracts was eight and, in some cases even zero (e.g. for interim contracts). Evidence shows that almost half of the job destruction during the period 2008–2010 was a result of this gap, which eventually led to the elimination of millions of temporary positions during the slump [7].

How to dismantle dual employment protection legislation

Due to the pervasive effects documented in the literature, and the economic inefficiency of temporary and unemployed workers being unable to achieve greater job stability and better future employment prospects, it would seem appropriate that policy should be directed towards closing the gap between the severance pay of permanent and temporary contracts. This has been the basic strategy adopted in the last three Spanish labor market reforms (2010, 2011, and 2012). Apart from other important changes regarding unemployment benefits and collective bargaining, these reforms have attempted to shrink the gap in termination costs between the two types of contract. However, the gap is still quite large: severance pay for temporary contracts is currently 12 days “pyos,” and the cost of unfair dismissal for all permanent contracts is set at 33 days “pyos,” following the labor market reform of 2012. As expected, this reduction has not been sufficient and the incentive for employers to hire under a permanent contract is still very low. For example, only 8.1% of all contracts signed in 2014 in Spain were permanent.

An alternative to these partial reforms would be to achieve a full convergence of employment policy through the elimination of most fixed-term contracts and the introduction of a single contract with termination costs that smoothly increase with job tenure and which is applied to all workers. In principle, termination costs could be chosen in a way that matches each country’s social and political preferences for worker protection, thus not necessarily implying convergence towards low degrees of employment protection. One of the first proposals in this vein was presented in April 2009 by a group of Spanish economists [8].

Their basic proposal was to suggest that severance pay should increase smoothly with job tenure (up to a cap) for all workers. The objective was to prevent “almost-sure” redundancy before the deadline at which a temporary contract (TC) has to be converted into a permanent contract (PC). Hence, they proposed replacing the existing system of TCs and PCs with a single open-ended contract (the so-called “single contract”) for new hires, with the aforementioned characteristics and two scales of compensation corresponding to fair and unfair dismissals. In particular, they suggested that compensation should be higher than it was at the time for TCs, and grow at a moderate rate (two or three additional days “pyos”) until it reached a value that is similar to the average severance pay in EU countries.

They also suggested that in order to maximize the social and economic benefits of the introduction of the single contract, a high degree of legal certainty should be reached in dismissal procedures. A further recommendation was that this contract could be part- or full-time and should be the basic hiring contract for all firms. (Though some other contracts may also be needed: for example, a well-designed training contract and an interim contract that could cover most companies’ needs to train and/or replace workers.)

Finally, temporary work agencies, which should also employ the single contract, could be used by firms to accommodate short-term hiring needs.

Figure 2 presents an example of a single contract that begins with the severance pay that currently applies to a TC in Spain (12 days) and concludes, after seven years, with the current severance pay for permanent contracts under unfair dismissals (33 days).

Similar proposals exist for introducing a single contract in some other European countries [9]. Although the details differ, the basic features are common. First, the distinction between a fixed-term and an open-ended contract, in terms of workers’ protection, disappears. Second, the increase in severance pay with tenure is gradual.

However, it is interesting to distinguish between two types of single-contract proposals. The 2014 OECD Employment Outlook surveys all single contract proposals in detail. The first type would introduce a new open-ended contract for new hires with an entry phase, during which worker entitlements, in the case of dismissal, are reduced and identical for both fair and unfair dismissal. It would also involve a “stability” phase, during which the worker would obtain the standard permanent contract with no changes in his or her rights in the case of termination. The main problem with this contract lies in the difficulty of eliminating the discontinuity induced by the transition from the entry to the stability phase, to the extent that worker rights in current, open-ended contracts are different in the case of fair and unfair dismissal. In general, therefore, employers would face a strong disincentive to keep their employees beyond the entry phase.

The second type of single contract proposal aims explicitly at avoiding discontinuities in severance pay. This idea includes a smooth increase in severance pay along with a redefinition of unfair dismissal, which is restricted only to cases of discrimination and prohibited grounds. One problem with this type of proposal, however, is that by tying workers’ rights to the specific firm where they work, it is likely to reduce efficient turnover and prevent mobility across jobs. In order to address this problem, the idea of a single contract based on rights to severance pay increasing with experience has also been explored. In this case, for the whole duration of the employment relationship, employers would pay additional social security contributions into a fund tied to the worker (as has been the case in Austria since 2003), which would be portable across jobs when the worker changes employer. Then, if the worker was dismissed, the fund would finance his or her severance pay. One disadvantage of this system is the creation of “excessive firing.” This is the reason why some economists would propose a mixed model, in which severance pay and a capitalization fund co-exist. The main objective of this is to restrict the application of “last in, first out” rules in firing decisions made by firms, by reducing the marginal cost of dismissal for all workers and thus promoting the continued employment of younger workers in the firm.

The OECD survey also explains that the implementation of a single contract might be in conflict with some ILO conventions (e.g. Convention 158) that require a valid reason to terminate an employment relationship and probationary periods of reasonable duration.

Finally, it is sensible to consider that some firms may see the single contract as a barrier to hiring if clear separation rules are not properly defined for short-term positions. In this sense, the strategy recently followed by Italy, which offers a fast-track way of firing workers, seems to be a good alternative in these cases.

Predicted effects of a single contract for Spain

One study presents a model that is designed to measure the effects of introducing a single contract in Spain, which involves severance pay, or compensation that increases in accordance with job seniority [10]. The study simulates the effects of the so-called “12–36 Single-Contract” (12–36 SC), in which the compensation begins at 12 days of wages “pyos” and increases by two days for each additional year worked, reaching a cap of 36 days “pyos” after 12 years of working at the same firm. The main goal of the simulation is to compare the effects of introducing this single contract with the effects of the fixed-term and permanent contracts that co-existed under the EPL situation in Spain prior to the 2012 reform. The main results from this simulation are that both unemployment and job destruction rates fall substantially with the introduction of the single contract. Unemployment drops by 31.5% (from 16.9% to 11.6%) and job destruction by 35% (from 12.6% to 8.2%).

Of particular interest in this study is the change in the job destruction rate for contracts with tenure equal to, or below, three years. In the dual labor market, the job destruction rate is very high because the large gap between the severance costs of TCs and PCs induces massive firings at the beginning of the fourth year in order to avoid the high future severance costs of PCs in the event of contract conversion. However, under the single open-ended contract, the probability of being fired in contracts with tenure equal to, or below, three years is reduced substantially (from 26.7% to 6.1%) because firms are less reluctant to destroy jobs. The reason for this is that it is more costly (12 days “pyos” as opposed to eight days “pyos” in TCs) and because the jump in severance pay (from eight days to 45 days) has been substituted for a smoother increase in severance pay. In other words, the pervasive incentives to destroy jobs at the beginning of the fourth year strongly diminish. The opposite happens, however, to the probability of being fired for workers with tenure of more than three years. Under the single contract, this probability increases from 7.4% to 9%. Hence, it emerges that as severance pay is smoothly increased, so are job destruction rates.

In addition to this, such changes in job destruction rates have a substantial impact on the tenure distribution. Indeed, the number of workers with tenure of just one year is 39.5% lower, and the number of workers with tenure above three years is 22.5% higher, under the single contract These changes are very significant, both in terms of human capital accumulation and experience.

With regard to welfare consequences, the same study also presents a transition exercise showing that the single contract would be highly beneficial for the majority of workers, and particularly for the unemployed, as their future job stability, once employed, would substantially increase. According to these calculations, less than 5.5% of workers would experience reduced tenure as a result of this reform, while 24.6% would not be affected and end up with the same severance pay and tenure as if the system remained unchanged. In fact, the majority of workers already hired under a PC would remain unaffected by the reform. In other words, there is not much replacement of these workers by new workers hired under a single contract. The underlying reason for this is that it is not optimal for firms to fire tenured workers due to the cost this substitution would entail. Furthermore, this contract would not necessarily increase the average expected severance cost for firms because job destruction would be lower than under the current legislation. In fact, the average compensation, weighted by the job destruction rate for any duration, would decrease by 9.1%.

A further advantage, from the firms’ point of view, is the reduced uncertainty due to the much simpler schedule of dismissal costs under a single contract. However, for this to be true, it would also be necessary to redefine the legal reasons for firing, so that uncertainty of both the type of firing and the official decision on its fairness is reduced.